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Apple's Cash Return Options: Pay Tax Man Or Raise Debt

It is safe to say that no one disagrees with the proposition that Apple‘s $137.1 billion cash position is more money that the company needs to operate its business. Last week, the simmering issue of what the company should do with the massive cash pile heated up last week after both Greenlight Capital’s David Einhorn and Legg Mason portfolio manager Bill Miller asserted that there is the potential for Apple’s stock to appreciate considerably with a creative distribution of its cash to holders in one form or another.

But the fact remains that not all cash is the same, and that in Apple’s case, $94 billion of the total is outside the country; the other $43.1 billion is held inside the U.S.

Bernstein Research analyst Toni Sacconaghi points out in a research note today that he expects Apple’s U.S. net income in FY 2013 to be about $12.4 billion, which he notes is lower than the roughly $13.4 billion the company has committed for dividends and share repurchases. In other words, for Apple to return more cash, the company will have to turn to some other source than domestic cash flow.

That would not be an issue, if not for the fact that profits repatriated to the U.S. are subject to hefty U.S. corporate income taxes.

Sacconaghi contends that Apple has two options on where to get cash to boost dividends and/or stock buybacks:

Option 1: Pay the tax man.

“One option that leaves Apple debt free and allows the company to significantly ramp its cash return is to simply repatriate future offshore earnings so all free cash flow is unencumbered,” he writes. “Deciding to pay tax on foreign earnings would negatively impact Apple’s earnings by 10-15% (assuming no changes in tax laws) but not impact the company’s future growth rate – arguably, 2013 would be a good time for Apple to do that, given earnings expectations are for 0% growth. This is a tack taken by Texas Instruments, and the company has returned an average of 138% of free cash flow to shareholders over the past ten years. For Apple, paying out 100% of its current cash flow after paying repatriation tax would amount to an 8% dividend, while returning 70% of ongoing cash would generate a current amount to a 5.9% dividend.

Option 2: Take on massive amounts of debt

Sacconaghi thinks the company could decide to take on as much as $50 billion to $100 billion in debt. He notes that this is a common route; companies that have gone in this direction to fund dividends and stock repurchases in the past include Microsoft, Dell and Cisco.

“Given prevailing interest rates (IBM issued $1.0 billion in 5 year notes at 1.25% last week), we believe that using debt to boost the return of cash to shareholders is an attractive option,” he writes. “$50 billion spent on repurchases would lower Apple’s share count by 11% or preferably, could be used to double the dividend (to ~4.6%) for five years (in which time cash repatriation laws may change; issuing a $100 billion would provide 10 years of cushion). We note that our analysis of AA- and above rated companies shows that Apple would have still have an above average net cash to market cap ratio versus other high quality debt issuers after issuing either $50 billion or $100 billion in debt, and a relatively average debt to market cap ratio at $50 billion in debt.”

The analyst notes that Greelight Capital’s idea of issuing perpetual preferred shares with a 4% dividend faces the same offshore cash restraint as other potential solutions for returning cash to holders.

Sacconaghi thinks the real issue here is for Apple to clearly state what it plans to do.

“Ultimately, we believe that the most important thing for Apple may be to be transparent that it is committed to returning cash to shareholders – i.e., announce that it intends to return at least 50% or 70% of ongoing [free cash flow] to investors every year, and then use a combination of vehicles (dividends and preferreds; borrowing vs. paying tax) depending on prevailing interest rate and tax environment to fulfill its intention.,” he writes. “We note that companies like IBM with a very high and transparent use of cash have been rewarded in the marketplace, despite low revenue growth.”

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